The Story of the Federal Reserve System

THE STORY OF THE

FEDERAL
RESERVE
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You're probably familiar
with one or more banks
in your neighborhood.

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Perhaps you or someone in

your family has a checking

or savings account at a

local bank,,.

... or perhaps someone in

your family has recently

taken out a loan ai a bank —

to buy a car. for example.

...tiut il does perform a variety of

task; to help the U.S. economy

function smoothly and meet

Che nation's economic goals.

The Fed is best known for its handling of monetary policy.

which consists of influencing money and credit conditions in the

econoniy in order to help the U.S. economy experience strong

growth in output and income, high employment, and stable prices.

The job of making monetary
policy often is a balancing

act, as the Fed has to make
sure that money and credit

don't grow either too slowly
or too rapidly.

I'm afraid you won't be

able to buy the car. Interest

rates are way up because there's

not much money to lend, and the

monthly payments at the higher rates

are more than you can afford.

I know you would like to expand

your factory, but because we don't

have much money to lend, we have to

charge a high interest rate. You wouldn't

be able to afford the monthly payments.

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So to try to prevent both recessions and inflation, the Fed has three main monetary
policy tools: open market operations, reserve requiremenLs, and the discount rate.

DISCOUNT RATE

MONEY

AHD

CREDIT

CONBiTIOHS

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Open market operations are
purchases and sales by the Fed of
U.S. government securities, which

are large lOUs of the (ederal

government. When the Fed buys

securities, it pays for them by

crediting the amount of the

purchase to the account that

the seller's banl< has at the Fed.

The bank, in turn, credits the

setter's account.

Thus, open market purchases by

the Fed provide the banking system

vjilh additional funds to lend.

In that way, open
market purchases
tend to lower the
federal funds rate,
the interest rate
that banks charge
each other on very
short -term loans.

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FEDERAL

RINDS

RATE

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A drop in the federal funds rate can

lead to a decline in the rates that banks

charge on loans and pay on deposits.

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The opposite occurs when the

Fed S'Mis government securities,

jn unusual occurence.

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The Fed collect? payment for the

securities by subtracting the amount

of the sale from the account that

the buyer's bank has ai the Fed.

The bank, in turn, subtracts

the amount from the buyer's

account. Banks row have less

to lend, the federal funds rate

may rise, and some borrowing

may be discouraged.

INTEREST
RATES

That means

people may

buy fewer cars

and businesses

may buy less

new equipment.

, Rather, the Fed deals with about twenty
. large firms - brokers and broker -dealers
- that buy and sell government securities
and can handle the large purchases and
sales efficiently, quickly, and safely.

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Indeed, the Fed's

□pen market operations

are conducted

electronically in a

matter of minutes.

When the Fed decides to change its
monetary policy, it uses open market
o-perations to implement the change.

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However, most of ihe Fed's open market operations
have nothing to do with changes in monetary policy.

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The Fed conducts open market operations several times a weel<

in order to prevent technical, temporary forces from pushing

money and credit conditions in some undestred direction.

One of these forces is the amount of cash in circulation.

The amount of cash that people have

with them is not constant. It varies

seasonally, by day of the month, and

even by day of the week.

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For eiaiiiij.e jiujii'-
use a Lol ul cash in bi iy
[ shopping seasons.

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Also, over the weekend, people use ATMs

to withdraw a lot of cash from banks

for shopping and entertainment.

I guess I m not the only

one who thought there'd be no line

at the ATM because everyone would

spending the day watching the

pro football games.

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Reserve requirements are another,

though far less frequently used,

tool of rnonetary policy. Reserve

requirements are the percentages

of certain deposits that banlts must

have either in their own vaults

or on deposit at the Fed.

For example, if the reserve
requirement is 10S, a bank
that receives a S100 deposit
must have S1 in its vault or
at its Federal Reserve Bank.

As the process continues, the banking system will expand an initisl $100 deposit into as much
as SI, 000 of deposits. These deposits are considered pail of liie nation's money supply.

$ioo+$9o+$8i+$yi.9o-

= $1,000

By law, the Fed can set the reserve requirement on checking accounts

anywhere from 85& to 1^*. If the requirement were 14%, rattler than 10^,

the bank that received the S100 deposit would keep SKon reserve

and lend a maximum of SB6, rather than 590...

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... and the next bank would be able to Lend
just 86% of $86. or S7i.'*, rather than S81 .

With a I'^'i'i leserve rf?quirenient, the banking system would be flble
to expand the initial SlOO deposit into )ust S7M. rather than S1 ,000.

$100+$86+$J3.96+$63.61+ ... + ... = $7^4

So, reserve requirements

are a powerful tool, as

they affect the abihty of

J the banking system to create

1 money. However, the Fed

rarely changes reserve

requirements.

14%'
13%'
12%-
11%'
10%-
9% •

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Since cutting the reserve

requirement on checking

accounts from M% to 10% in

April 1992, the Fed has not

changed the requirement.

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Also, when the Fed has to reduce the growth of

money and credit, it would rather not do so by raising

reserve requirements, because the requirements

impose a kind of tax or cost on banks.

Still another tool of monetary policy involves the

discount rate, the Interest rate that the Fed charges

banks on short-term loans. Changes in the discount

rate can influence other interest rates.

Percent

However, the Fed often implemerHs changes in
monetary policy without changing the discount rate.

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FEDERAL FUNDS RATE

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For example, between

mid-1995 and the end of

1998, the Fed changed its

target for tlie federal

funds rate on seven

occasions, but on only

three of those occasions

did it change the

discount rate.

The discount rale
refers to a primary credit

rate on loans to

the financially strongest

banks and a higher

secondary credit rate

on loans to oiher banks.

The Federal Reserve also affects the U.S. economy when it intervenes for the U.S. monetary

authorities the Treasury Department and the Fed - in the foreign exchange markets, in which

dollars are exchanged for foreign currencies such as the Japanese yen and the euro.

The foreign exchange (FX) value of the dollar is growing in

importance as international trade and finance expand.

Exports, for example, now account for almost 12^ of the output

of the U.S. economy, up from less than 5% in the early '60s.

The FX value of the dollar can affect the
economy in a number of ways. If the dollar
appreciates (rises in value), foreigners have
to pay more in their currencies to buy U.S.
goods. The higher effective price, in turn,
could lead foreigners to buy fewer U.S. goods,
causing some U.S. companies to lose profits.

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On the other hand, if the FX value of the

dollar falls (that is, the dollar depreciates

U.S. consumers have to pay more for

foreign-made goods, and that could help

cause inflation in the United States.

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On occasion, the U.S. Treasury
Department and the Fed decide
to Intervene in the FX market.

These interventions are small compared
with the total amount of FX trading, so
they don't influence supply and demand

conditions in the currency market. Rather,
they influence market sentiment relating

to the foreign exchange value of the dollar.

So far, we've seen that the Fed has various ways to foster a healthy

economic climate. The Fed also provides banks with services that

help the economy function smoothly. Some of these activities

make it easier for people to make payments. For instance, the

Fed provides banks with cash to meet their customers needs.

On the other hand, when banks

have more cash than they need,

they ship the excess to the Fed

for credit to their accounts.

TTie Fed uses high-speed machines

to count the bills that the banks deposit.

These state-of-the-art machines also

check the denomination of each bill.

The machines also spot
possible counterfeit bills...

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ills... I

...and identify bills thai are worn and not fit for

continued use. Another machine shreds those bills

which are then disposed of at landfills.

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While cash is iisen fof some transactions in the economy, checks are used for many others,
and the Fed pronessfs about one-third of all the checks written in the United States.

Suppose you live in California and
you send a check to a company in
New York to pay for some clothing.

The company in New Vori- v^ 11

deposit the check in its bank,

which will credit the amount of the

check to the company's account.

In many cases, the bank will then

send the check to the Federal

Reserve Bank of New York, which

will credit the amount to the

account that the bank has at

the New York Fed.

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The New York Fed will then send the check to the Federal Reserve Bank of San Francisco, which will subtract the

amount of the check from the account that your bank has at the San Francisco Fed, and then send the check to

your bank, which will subtract the amount from your account.

New York Fed

San Francisco Fed

YL1UR ACCOUNT
2,530

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2,S00

While cash or checks are used
for most transactions, the dollar
volume of electronic payments
is much larger than that of
checks and cash combined.

The Fed also pjuvide-i

loans to banks under

certain circumstances.

F Banks typicaily borrow
from private sources. Out
may come to Federa
Reserve Banks when private
funding is not available or
temporarily too co^nv.

Since 2003, the interest rate v^tiich banks pay when they borrow from the Fed has been higher than the
federal funds rate, the interest rate at which banks with extra reserves lend to banks that need the reserves.

I don't have enough
f reserves to meet my
Vreserve requirement.

As of 2003, banks are permitted to borrow from
the Fed at the primary or secondary credit rate
and then turn around and lend to other banks.

However, smce the primary and secondary credit rates

are higher than the federal funds rate, opportunities

to make profitable loans to banks are few.

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The Fed has a special lending program,

seasonal credit, for banks that face severe

seasonal pressures each year - at certain

times of the year, the banks have only

limited deposits and they face a large

demand for loans.

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Under the seasonal credit program,

banks can borrow for up to nine months

each year. Most of the banks that use this

program are in agricultural communities.

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The Fed also performs financial
services for the U.S. governmeni.

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Thus, people who get federal income tax refunds,
whether by check or by electronic payment, receive
the payments from a government account at the Fed.

The farmers have to

borrow now to plant their

crops, and they won't tie sending

us many deposits until they harvest

the crops. We may have to ask the

Fed to give us a loan until then.

The government didn't

have to sent) you a check.

Your tax refund was deposited

I your account electronically.

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Now, debt or lOUs that the federal govern ment issues exist only

as electronic records, individuals may put these electronic

securities in Legacy Treasury Direct accounts,

KoUrT
BANK.

/>iOw you wont have to worry
' that your Treasury securities
might be destroyed In a fire,
and you won't even need a safe
deposit box to store them.
They're perfectly safe as
-electronic securities.

Another responsibility of the Federal Reserve

(one that it shares with some other government

agencies) is to supervise banl<s in order to

make sure they operate safely and soundly,

and are sensitive to risks.

For example. Fed bank examiners look at banks' financial

statements to make sure that the banlts have enough capital

{funds of their own) to withstand risks from a downturn in

the economy or unpaid loans.

The Fed also examines banks' operating procedures

to make sure that they are not too susceptible
to theft or fraud by their employees or by others.

J I'll change the
password right now, and
t won't give anyone the
new password.

When the Fed finds a problem in the way a

bank operates, it often can be resolved without

penalty or any other supervisory action.

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In more serious cases, the Fed can fine

banks and individuals, and in the most

entreme cases, it can even close a bank

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Another' law enforced by the Fed is the

r.iir Credit and Charge Card Disclosure Act,

Ahich says that appUcations for credit cards

mjst tell you wliether you have to pay an

annual fee for the card and what interest

rate you have to pay on the balance in

your account.

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To get this credit card, yoi

have to pay a $20 fee each yea'.

On the other hand, the interest rate

^.□n this card is lov/er than what somi;

of the other cards chiirge

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We've looked at many of the
activities that the Federal
Reserve performs. Let's look
now at tlie different parts of
the Federal Reserve System
and what each part does.

The System is headed by

the Board of Governors.

I which is in Washington, D.C.

The Board of Governors consists of seven members, appointed

by the U.S. president and confirmed by the U.S. Senate.

Governors are appointed to Myear terms.

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These- terms are much longer than those of the president,

ii^'n.ilors, or members of" the House of Representatives.

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Also, the 14-year terms are staggered. That means they don't all expire at

the same time. One term expires every two years. The staggered M-year

terms reduce the influence of politics on the Fed,

If all the Feds governors

complete their terms, I'll be ablel

to appoint only two governors

in my four-year term.

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Another factor ttiat

promotes the Fed's pohtical

independence is that the

Fed does not have to

reiy on appropriations

from Congress.

The Fed Is financially self-sufficient.

Its income comes predominantly

from interest it receives on its holdings

of U.S. government securities.

Not only is the Fed financially

self-sufficient, but it actually takes

in much more income each year

than it spends. The Fed returns to

the U.S. Treasury the excess of what

it takes in over what it spends.

Of course, the Fed's

independence is far from

total. By law, the chairman

of the Federal Reserve has

to testify tiefore Congress at

least twice a year regarding

the Fed's monetarv policy.

Also, it was Congress that created

the Fed. The U.S. Constitution gives

Congress the power to coin and

regulate the value of money, and

Congress has decided to delegate

that authority to the Fed, At times.

Congress has changed the Fed's powers.

7 UNITED STATES '

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For example, in 1980, Congress

passed a law saying that all banks

in the United States have to meet

the Fed's reserve requirements.

Until then, only banks that

belonged to the Federal Reserve

System had to meet them.

If alt banks have to

meet the Fed's reserve

requirements, the Fed will

^be able to do a better job of J

influencing money and

credit conditions.

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In any case, the Fed is more

independent than other parts

of the government.

Interestingly, other countries have taken steps in recent years
to increase the political independence of their central banks.

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That's because independence helps a central bank focus on

long-term economic problems. Indeed, research shows that countries

with more central bank Independence tend to be more successful

in controlling inflation than other countries.

CENTRAL BANK INDEPENDENCE

In addition to the Board of Governors,

the Fed consists of 12 Federal Reserve

Banks spread around the country. The

Reserve Banks provide financial services

for the U.S. government, supervise banks

in their districts, and provide banks with

services, such as the provision and storage

of cash, loans, and check processing.

This map shows the location of the Reserve Banks and the district
that each one serves. As shown on the map, the Reserve Banks are

concentrated in the eastern half of the United States. That's because
when the Fed was created, U.S. population, business and financial

activities were far more concentrated in the east than they are now.

oston

'New Yorh
Philadelphia
Board of
Governors

Richmond

("""" — -5 O U.S. Vli^ln

Puerto Rleo t-^^^

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Both the Board of Governors and the Reserve Banks play a

role in the monetary policy process. The Board of Governors

sets reserve requirements.

Each Resetve Banl< sets its primary and secondary credit rates

every two weeks, subject to the approval of the Board of

Governors. (Because the United States has a national credit

marltet, the discount rate, and now the primary and secondary

credit rates have, for many decades, been uniform throughout

the Federal Reserve System.)

Meanwhile, monetary policy is

determined by a group called the

Federal Open Market Committee (FOMC),

which meets in Washington, D.C.,

eight times a year.

The meetings are attended by the

members of the Board of Governors

and the presidents of alt 12 Reserve

Banks. There are only 12 voting

members, however -the seven governors

and five of the Reserve Bank presidents.

^^^ York

There are several reasons why the president of the New York Fed is a
permanent voting member of the FOMC. One is that the New York Fed

oiiriLnts M the open rnark'.--'. operations for the Federal Reserve System

In addition, when the U.S. monetary

authorities intervene in the foreign

exchange market, the intervention is

carried out by the New York Fed,

The Federal Reserve Bank of New York also provides a
variety of service; to foreign central banks.

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For example, the New York Fed stores tjillions of dollars' worth of gold

for foreign central banks. The gold makes a dramatic sight, and the

Federal Reserve Bank of New York invites visitors to see it.

(Indeed, each year, more that 25,000 visitors do just that.)

Fewer than half the banks in the
country —about 33%- are members

of the Federal Reserve System.
However, they tend to be the larger
banks, and they have about eighty

percent of all U.S. bank deposits.

NUMBER
OF BANKS

The member banks choose six members of the board of directors
of their local Reserve Bank, and the Board of Governors chooses the
three other directors, including the chairman and deputy chairman.

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II

To order publications online, go to:
www.newyorkfed.org/publications

Information about the Federal Reserve

Bank of New York's education programs

can be found at:

www.newyorkfed.org/education

Federal Reserve Bank of New York

Public Information Department

33 Liberty Street

NewYork, NY 10045

(212)720-6134

www.newyorkfed.org

2008

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